Growth in energy consumption is not just a by-product of economic growth, it is a causal factor. Reducing greenhouse gas emissions requires reducing energy consumption. Attempts to constrain energy consumption can therefore be expected to impede economic growth. We need to understand this trade-off in order to measure the full costs of climate policy plans.

The spread of electricity and household appliances results in increased convenience, reduced indoor air pollution and improved health through better food handling and indoor climate control. The availability of inexpensive electricity has truly been a miraculous source of economic growth, social progress and equality in the west. Greenwood et al. (2005) showed that, in American households, the proliferation of household appliances, made possible by the spread of electricity, reduced required average housework time from 58 hours per week to 18 hours per week between 1900 and 1975. This can also be expected for other countries, namely that increased productivity in the home leads to more time for participation in the paid workforce.

Empirical literature shows that increased energy consumption is an input to growth and cannot be easily decoupled from economic development. The results from numerous studies by Stern (2000), Ghali and El-Sakka (2004) and others using different country data show that increased energy consumption leads to growth, and in some cases the apparent causality runs in both directions. This indicates that reduced energy availability is likely to be a constraint on economic growth, rather than energy consumption being an unnecessary by-product of economic growth.

Fossil-based energy has cost advantage over alternatives but gives rise to pollution concerns. Conventional air pollution is not a necessary by-product of power production and has been successfully decoupled from it in western countries through development of scrubbers and other end-of-pipe treatments. Emissions of direct air contaminants like SO2 and particulates have been sharply reduced — to the order of 80-95% in western countries despite decades of concurrent growth in energy use and output. The availability of scrubbers and other end-of-stack emission controls, more efficient fuel burning systems, higher quality fuel sources and similar technical innovations have been extremely effective in allowing western countries to increase their energy use while cutting emissions. Indirect air contaminants, such as ozone and aerosols, are not trending upwards and peak level episodes have fallen, but the complexities of the atmospheric processes in these cases make progress inherently slower.

Carbon dioxide is not controllable by conventional scrubbers, instead it is tied linearly to energy consumption. CO2 emission reductions will therefore be much more expensive to achieve under current technology. So, in effect, CO2 emissions cannot be decoupled from economic growth except by the slow process of increasing energy efficiency, or switching from coal to oil or gas for electricity production. Since coal has, historically, been the cheapest form of fossil energy for electricity production, as well as the easiest to transport and the one most widely available, it has an advantage in terms of cost and convenience. Since it is also the most CO2–intensive form of fuel, this means that CO2–intensive power generation has a relative cost advantage over other forms. Coupled with the absence of scrubber technology, we understand the reason why attempts to reduce CO2 emissions sharply can be expected to have serious economic consequences.

Against this background, economic reasoning provides a few basic ideas for guiding energy and pollution policy. Regulations should be focused directly on the variable of interest, not on indirect market transactions. Whatever the matter for regulatory concern, efficiency is aided by targeting the intervention on the specific issue itself, rather than on secondary issues or matters only partly connected to it. If the issue of concern is the sulphur coming out of a smokestack, implement policies that regulate the sulphur coming out of the smokestack. Do not implement policies that tell customers hundreds of miles away from the smokestack how they should act, in the hopes that this will affect how much electricity they use and, eventually, how much sulphur comes out of the smokestack. It would be more effective and efficient simply to regulate the sulphur emissions themselves and leave the remaining decisions about electricity supply and demand to market participants. The idea, once grasped, is intuitively obvious, yet modern environmental policymaking seems to have completely missed it, as evidenced by the proliferation of rules about appliance standards, light bulbs, windmills, etc., all of which are done in the name of controlling emissions coming out of power plant stacks.

No conceptual difficulties emerge when incorporating pollution externalities into the standard market model. If external costs were dealt with using price instruments, the basic insight of environmental economics is that, rather than subsidizing indirect control measures or regulating quantities in related markets, emitters should pay a fee per unit of emissions that reflects the marginal social cost of their actions. A few key points need to be kept in mind. First, the optimal policy applies to the emissions themselves, and nothing else. Any additional price or regulatory intervention (such as subsidies for alternative energy) must, by necessity, make it costlier to achieve the same outcome. Second, the optimal policy should take the form of a price on emissions set somewhat below the estimated marginal damages, with the reduction proportional to the inverse of the marginal cost of public funds. The reason for this condition has to do with the distortions created elsewhere in the economy by the necessity of funding the government using a tax system, which inflates the cost of providing public goods, including pollution control.

The integration of pollution control into optimal economic policy can be achieved naturally in a framework in which the policy targets the emissions price, rather than the quantity. Only in very simplistic frameworks is there symmetry between regulating price and regulating quantity. Some policy analysts mistakenly assume that the two are always interchangeable. In the carbon policy world this means that policymakers are sometimes told that it makes no difference whether they opt for a carbon tax or a tradable permit (cap-and-trade) system. But this is incorrect for two reasons. First, pricing instruments raise revenue by capturing all the scarcity rents. Any policy that limits a valuable activity (such as by imposing emission reductions) creates gaps between the cost of providing a good or service and the return on it at the regulated margin. These gaps create windfall gains, or “rents” as economists call them. Caps on emissions also create rents, but they are hidden in layers of economic activity and accrue to industries and investors in ways that can be difficult to predict. They are not new wealth, instead they represent transfers of wealth from consumers to producers. If the regulator uses cap-and-trade, issuing permits and then allowing firms to trade them, the value of these rents becomes visible as firms bid for the permits. It is possible to capture the rents from tradable permits by auctioning them rather than giving them away free, but this practice has been rare. Hence quantity and price controls are not symmetric in their overall macroeconomic costs, since quantity controls typically fail to capture the rents created by the policy and this adds to the costs to households.

Second, the symmetry between price and quantity breaks down when there is uncertainty. A regulator can target the emissions price, and let the market determine the resulting quantity, or he/she can target the emissions quantity, and let the market determine the price, but he/she cannot determine both. The “price” of emissions corresponds to the marginal cost of emission reductions, or the marginal abatement cost. Having targeted the quantity of emissions, the market will determine the marginal abatement cost. If the regulator intends to target the marginal cost, the market will determine the resulting quantity of emissions. There is an inverse relation between the marginal cost cut-off and the volume of emission reductions that can be achieved. The higher the acceptable marginal cost of abatement, the lower the resulting emissions level will be. The lower the acceptable marginal cost, the higher the resulting emissions level will be. Economists have shown that using price-based emission reduction policies for globally-mixed pollutants with steep marginal abatement costs — which describes the CO2 case — leads to lower uncertainty costs, or in other words lower costs associated with errors in choosing the right level of policy intervention.

Real climate policy ignores much of the fundamental messages of economic reasoning. Hence we see huge inefficiencies and small outcomes of climate policy. As long as political, ideological and distributional motives trump reason and rationality in climate politics, we will face a huge burden for humanity.

This post is a condensed version of Ross McKitrick’s “Energy, Pollution Control and Economic Growth”, Occasional Paper 52, 2012.